Financial losses come in many shapes and forms and investors rightly spend a considerable amount of time worrying about them but managing loss aversion poorly can make the long-term outcome even worse. It is important to pick the right battles, to trade off cost of protection with loss severity and to not lose sight of the ultimate investment goals.
How people perceive financial losses and how they would behave pre-emptively in the expectation (or fear) of potential drops in their portfolio value is highly personal, as it depends on a combination of experience, emotions and personality. However, we, in our aim to act as rational investment professionals, focus on understanding three things: how a potential risk affects the long-term performance versus the objective, what can be done to reduce the chances of this happening and how its cost compares to the long-term benefits.
The impact of losses must be measured across two dimensions: space and time. The deeper the loss or the longer its duration, the more the portfolio will have to recover from a drawdown to achieve its investment goal over the investment horizon. It’s intuitive, but here is where the first irrational behaviour appears: people tend to be more afraid of an overnight 30% crash than one of similar depth but spread over, for instance, 2 years. The former is more extreme and highly unusual, but the latter is more detrimental to long-term returns as it not only erodes capital, but time too.
Long-term destruction of capital can be mitigated, or even avoided, by effective asset allocation and diversification. Asset classes such as defensive equities, high yield bonds or emerging market debt can help mitigate equity risk without significantly affecting the overall portfolio expected return, while government bonds, cash, gold or liquid alternatives can offer even lower correlation to risk assets, with the main drawback being lower long-run expected returns.
Extreme, sudden losses, such as that which global equities experienced earlier this year (-34% in USD in just over a month), are instead very hard to completely hedge against as they are often accompanied by a lack of liquidity and widespread selloffs across most asset classes, dramatically reducing diversification benefits. One of the few effective ways of protecting capital (or even posting substantial gains) during sharply falling markets is by betting on an increase in volatility via put options or via futures on volatility indices. For instance, buying short term futures on the CBOE Volatility (VIX) Index would have returned +300% during the Great Financial Crisis and +350% during this year’s rout. Similarly put options can be used to cap the maximum loss a portfolio can suffer. The caveat is that these strategies are very expensive and tend to bleed value every day that such wide moves do not happen: the same volatility-buying strategy has indeed lost 40% per annum, on average, since Dec ’05 to today. Therefore, continued long volatility exposure makes financial sense only when driven by a short-term negative view on equity markets and a fair assessment of costs and benefits.
At Momentum, we spend a lot of time considering downside risk scenarios and always strive to provide our clients with a more stable journey toward their goals. Our multi-asset, multi-strategy portfolios offer ample breadth along with genuine diversification and are strategically built to offer the best expected long-term outcome given a certain risk profile. On an ongoing basis, though, we also assess market conditions and shorter-term dynamics and tilt our portfolios accordingly, always mindful of costs, potential outcomes and, of course, the chances of our views being wrong.
James Klempster, CFA
There’s no two ways about it: size matters. We live in a society that admires big, yet also reveres the precision of small. When it comes to disadvantages, both large and small can be found wanting. Needless to say, in the world of fund management things are equally nuanced.